Variable Annuities Overview

October 28, 2009

Variable annuities are probably something you’ve never even considered investing in if you’re under 50 years young.  However, I’ve had people write me whose parents are getting pitched fixed annuitites and variable annuities as they are getting closer to retirement. To give an idea of how variable annuities work, Victor wrote up the following overview. [Editor’s Note].

What is a Variable Annuity?

Like a fixed annuity, a variable annuity is an insurance product. The difference between the two is the opportunity for more growth and risk. In a variable annuity, an investor’s funds can be invested in mutual fund-like products wrapped inside the annuity. The value of the annuity fluctuates daily based on the performance of the chosen portfolio.

Many annuities now offer certain guarantees. An investor can purchase principal protection where they are guaranteed every penny they put in. Some also offer guaranteed growth. They will have an offer that states the investor will receive 5% or the market performance of the portfolio, whichever is higher. Both of these options are nice to have, but an investor must realize that they pay for this. These are “riders” that are added to the annuity contract and have fees associated with them.

Liked fixed annuities, variable annuities have the same type of surrender schedules. A portion may be taken out without being charged a fee, but be aware that if you have not reached 59 ½, you may be subject to an IRS penalty of 10%. All growth is tax deferred in a variable annuity.

In a variable annuity, the funds are passed directly to the beneficiaries without going through probate. In the case of a spousal beneficiary, if the option is chosen, the spouse can continue the contract as if it were theirs. These annuities, again like their fixed counterparts, can be funded with a lump some or through periodic payments.

Typical Investor

In most cases, the typical investor of a variable annuity is retiree or a person with retirement on the horizon. Some annuities don’t even allow you to purchase them unless you are 45-50 years old. For some people, these newer annuities that include so many guarantees seem too good to be true.

Make sure you know how much it will cost to get all of these “guarantees” in an annuity. You will also want to know what kinds of investments are available inside the annuity and the health of the insurance company that is selling the annuity.

An annuity can be a very confusing thing. Annuity contracts are long and filled with “legalese.” Make sure you understand everything or speak to a financial professional and have them explain it to you before you put any money into it.

Here is a Smart Money article that takes a look at the downsides of variable annuities such as the average annual fees & commissions they charge, surrender fees, taxes on gains, and estate planning concerns.



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5 Responses to Variable Annuities Overview

  • Anonymous

    wooo hooo

  • Bonnie

    Joe, you’re confusing equity-indexed annuities with variable annuities. Also, to do a true comparison of various VAs, you have to run illustrations assuming a zero percent rate of return. That’ll show you the effect of fees on different VA products.

    Victor, the only financial advisors glossing over fees are those that want to lose their license. With VA guaranteed income riders, you’re paying a fee (often close to 1% nowadays) to insure a portion of your retirement assets and guarantee that you won’t outlive the income derived from that account, without having to annuitize and also with the potential to benefit from market gains. There are no guarantees without paying for the insurance (i.e. annuity rider) on the assets. Otherwise, you’d have a plain old mutual fund, which is fine for younger investors, but may not cut it for the 70% of people retiring without a traditional pension. Simply recall 2008 and the many retirees who were forced to go back to work because the income used for essential expenses came from non-guaranteed sources (i.e. other than pensions, social security, and annuities).

  • Victor

    Joe, You are absolutely correct. This product is good in the RIGHT spot for the RIGHT person. As a financial advisor, I watched other professionals pitch these and hang their hat on that “guarantee.”

    Those fees are usually glossed over. For some people, the fee won’t matter because they want to feel safe and know that income will be there.

  • JoeTaxpayer

    I’ve sifted through the prospectus of many a variable annuity, and not found one worth my time. The 5% or market return must have a catch, it’s usually not the full market return but either a fraction, maybe 75%, or a cap, say 10%. In the end, there’s some comfort in feeling you’ll never have a negative year, but over time the fees eat you up.

    I’d love to see a link to a VA that someone is wiling to recommend, and see an analysis of how it would perform over time.


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